05-28-07

In terms of cause and effect, many assume that markets behave like a game of checkers. Action ‘A' supposedly results in consequence ‘B', with little doubt of the straightforward result.

In reality, markets are less like checkers and more like chess. Because all the pieces move in complex relationship to one another, minor details matter. It isn't always clear whether a specific move is an excellent one, or a terrible one. Subtle differences can lead to unexpected outcomes.

This week Macro Musings looks to the Middle East, highlighting two examples of how this is so.

But before we head over there, let's first set the stage with a quick refresher course. (The conventional wisdom must first be explained before turning it on its head.)

Investors quickly learn of the relationship between stocks and interest rates. When rates are low or falling—that is to say, when monetary policy is "loose"—the stock market tends to do well. Conversely, when interest rates are high or rising—i.e., monetary policy is "tight"—the stock market tends to do poorly.

This is so because lower interest rates make it easy to borrow, which in turn makes it easier for businesses to expand and consumers to spend. On the other side of the coin, when monetary policy is tightening, it becomes more expensive to borrow… and thus business and consumer activity is reigned in. (Higher interest rates also increase the relative attractiveness of savings accounts, lowering the general appetite for stocks.)

Wall Street has immortalized the relationship between stocks and interest rates in various ways. One of them is the simplistic but popular "Fed model," which benchmarks earnings against interest rate yields. Another example is the old "three steps and a stumble" cliché, a rule of thumb stating that stocks are likely to fall after the Fed hikes rates three times.

There are still other examples. The bottom line is, low rates are deemed good for stocks, and higher rates bad. Picture a see-saw, with stocks on one side and interest rates on the other. When the general direction of one is up, the other should be down. Again, a very simplistic picture. Market bulls have been vigorously pounding the table with this imagery, and continue to do so.

So now we get to the fun part. What if there is more than one way to connect these dots? What if there are occasions when the traditional relationship gets flipped around, such that lowering interest rates causes the stock market to fall too?

That is precisely what happened in Iran just recently. On Friday the UK Guardian reported:

Iran's financial system suffered a fresh jolt yesterday with panic selling on the stock market after the president, Mahmoud Ahmadinejad, abruptly ordered banks to cut interest rates sharply, despite surging inflation.

The order... has triggered warnings of a financial crisis and spiralling corruption amid fears of a capital flight from the country's lending institutions.

Mr Ahmadinejad's decree forced all state-owned and private banks to slash borrowing rates to 12%. Inflation is officially 15% but is generally believed to be much higher. State banks had been offering rates of 14%, while those in the private sector ranged from 17% to 28%.

The decision caused panic in the Tehran stock exchange, with private banks losing much of their share value overnight. Shareholders in one bank, Karafarin, queued on Wednesday to sell their stock when previously there had been 1.2 million applicants to buy its shares.

Ah, there's the rub—inflation. When rates are cut in the teeth of rampant inflation, the market result is panic, not euphoria.

Iran's economists were uniformly horrified by Ahmadinejad's move. The country's economy minister was not even informed of the decision beforehand, let alone consulted as to its wisdom. Iran's moderate press responded to the news with phrases like "incomprehensible" and "economic suicide."

Why has Ahmadinejad done this? Hard to say. Rumblings of economic discontent in Iran have been growing for quite some time. Outcry over skyrocketing fuel prices (which the government can no longer afford to subsidize) may have been a concern. Iran's president may simply be cornered and flailing about, hoping that a hail-mary populist gesture will save him.

The reasons aren't particularly important in this case; as the old saying goes, there's just no accounting for stupidity or taste. (Or madness for that matter.) What we see here is a case where lowering rates creates a decisively ugly outcome for stocks.

Our second example is a saner and happier one.

When it comes to inflation (and perhaps other things), the folks in Kuwait—a small oil producer on the Persian Gulf—have a mindset very different than Iran's.Inflation in Kuwait is still quite moderate relative to the other gulf states, but it is high enough for the economic authorities to show real concern.

In light of those concerns, Kuwait has decided to abandon its dollar peg. The Wall Street Journal explains:

Kuwait dropped its currency's four-year-old peg to the falling U.S. dollar and switched to a basket of currencies, raising new questions about plans for a currency union with other Gulf Arab oil producers. Kuwait's central-bank governor said his country was still committed to the union and was acting in the "national interest" to contain inflation.

Members of the GCC (Gulf Cooperation Council) had been planning for a Euro-style currency union to take place by 2010. In spite of Kuwait's soothing words, it is now widely agreed that the 2010 deadline will be impossible to meet. As a result of Kuwait's actions, the logistics of currency union, quite possibly a terrible idea in the first place, have simply become too complicated.

Some speculate the other oil-exporting countries in the GCC, many of which are dealing with inflation levels higher than Kuwait's, will have to follow suit and drop the dollar too, lest inflation overwhelm them. Greenbacks have been flooding into oil-exporters' coffers as a result of higher oil prices; in spite of central banks' best efforts, it is impossible to stamp out the inflationary pressures of such a gusher without letting the home currency rise. (Or, at the very least, ceasing to follow the dollar down.)

This is more bad news for the dollar, of course. But here is another odd thing. Remember that relationship between stocks and interest rates? In caveman speak, "loosening monetary policy GOOD, tightening monetary policy BAD."

We saw how Iran turned that upside down—how loosening monetary policy in the teeth of rampant inflation is actually quite bad. (Awful even.) Now, with Kuwait, we observe another strange situation, where tightening monetary policy can be good for stocks. From Reuters last week:

Kuwait's bourse rose to a 14-1/2-month high on Tuesday as its rally gained more momentum from investor expectations that the dinar will rise after the central bank abandoned its peg to the dollar.

... "There is a great expectation that the dinar will go stronger. Stocks are one avenue for international investors to take advantage of Kuwait dinar appreciation," said Talal al-Tawari, head of the GCC equities division at Kuwait-based Gulf Investment Corp.

In response to Kuwait's hawkish news, the Kuwaiti stock market went up for many days in a row. Why? Investors want dinar-denominated assets to participate in the Kuwaiti currency's rise, and stocks fit that bill. There is a belief that Kuwait's economy is strong enough and resilient enough to continue doing well, even in a tightening environment. This encourages investors to move away from dollars and towards dinars.

So here you have two phenomenon representing the inverse of the expected. In Iran, a loosening of monetary policy leads to panic. In Kuwait, a hawkish stance leads to a general increase in stock market bullishness.

Interesting.

The uniting thread here (for our purposes) is the fate of the dollar, and the role that export-led economies will play in it.

Iran's move foreshadows a time when the US federal reserve is forced to cut interest rates against its better judgment. Piling on the debt is an effective way to postpone the inevitable, but it only makes conditions that much more harsh when the inevitable comes to pass.If and when the Fed has to slash rates in the teeth of inflation, such a move could have a similar effect to Ahmadinejad's... with gold the ultimate benefactor.

On the other hand, Kuwait offers a foreshadowing of the actions of export-led countries awash in dollars, looking to dampen inflation and stand on their own two feet.

Central banks the world over, as we know, have amassed huge piles of US currency. They didn't do it for charity's sake. When the time is right, export-oriented countries will find their own footing (via internal domestic demand) and let their currencies gradually rise. As with Kuwaiti dinars, this will increase demand for ringgits, reals, rubles, baht, yuan, and so forth… and lower demand for dollars in the process.

Furthermore, as the currencies of export-led countries gradually strengthen along with their economies, trade between these countries will increase. (If Russia and China both let their currencies appreciate, for example, the relative cost of goods exchanged between them stays the same.) The more countries that go the way of Kuwait—securing continued investment via tighter monetary policy as they stand on their own two feet—the less attractive the dollar becomes.

The scenario just outlined, in which strengthening exporters kick the dollar habit a' la Kuwait, is rooted in the concept of "desynchronization," the idea that the rest of the world will not be dragged down by economic weakness in the United States. Economists are much divided on this notion. Some believe that the traditional ties have finally been severed, and that desynchronization is undeniably here. Others still hold to the older notion that, "when the US sneezes, the world catches cold."

Either way, demand for dollars is set to fall. If countries like Kuwait find themselves stumbling in the event of global economic slowdown, they will have mountains of dollars in central bank reserves to sell, and will be taking in fewer of those dollars in the first place. If these same countries remain strong, they will move away from the dollar as their own strength is confirmed. This also means that, either way, many of the best investment opportunities will be found outside US markets in the coming years.

The real money-making effects of all this—the paydirt for investors, if you will—comes when the next downturn hits the United States... or an outbreak of inflation rolls in too serious for government statistics to cover up... or both at the same time.